“There are known knowns. There are things we know we know. We also know there are known unknowns. That is to say, we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know.”
—Donald Rumsfeld, former Secretary of Defense
The first quarter was both, a mix of a known unknown (a virus, which while this latest outbreak was a potential unknown, we do know that a virus can rear up and strike unexpectedly like swine flu and SARS have done in the past) and an unknown unknown (the impact and speed of a virus spreading around the globe) wreaking untold havoc on the global economy. For further clarification regarding the quote above, Donald Rumsfeld was not the person to first discuss an “unknown unknown” or as some also call a Black Swan event. Rumsfeld's famous quote is commonly cited as growing out of work done by two American psychologists in the 1950s. More recently, significant events and how they relate to economics and society were discussed extensively by Nassim Taleb in his now-famous book The Black Swan. For clarification, some points of discussion related to this topic should be made as they can frame how we look at the current crisis.
Mr. Taleb was the lead quote for last quarter’s newsletter. In this, he commented on the futility of “experts” and their predictions. How accurate this comment is in light of our current situation with the coronavirus is humbling. Second, The Black Swan is one of the best books I have ever read as it relates to the misconceptions of random events in financial markets and overall life in general. The concept of the Black Swan, in a very simplistic explanation, emanates from the commonly held belief that all swans were white, until the discovery of black swans in Australia. This proved wrong, a whole host of scientists and intellectuals over many centuries that argued there could not be an existence of anything but white swans, because that was all that was historically observed in nature. Now to clarify, the potential for this virus was known, it’s the after-effects of economic shutdowns and associated potential system breakdowns that are a true unknown unknown.
Efforts to control the virus (a known unknown) are now the catalyst for a series of unprecedented lockdowns of unknown duration, social distancing measures, destruction of the travel/tourism and hospitality industry, and cancellations of all large-scale gatherings which are combining to produce record levels of unemployment and economic contraction not seen since WWII or the Great Depression. Or as Mr. Taleb might summarize, an initial event reacts within a complex system to create unknown negative consequences which are a true Black Swan event.
Before we launch into the economic pain currently being felt across the country and the world, some perspective is in order. The finger-pointing about who knew what when, and their failure to act and the associated damage that has caused has already begun. And, we are nowhere near the finish line in this current crisis. Initially, this outbreak was called the Wuhan Virus and now to be clear, COVID-19 refers to the disease of coronavirus. “Co” refers to corona, “vi” to the virus, and “d” to disease, and 19 in COVID-19 refers to the year it was first noticed. The virus that causes the disease is SARS-CoV-2, was named by the International Committee on Taxonomy of Viruses.
It must be noted that the first information regarding this new and novel coronavirus started trickling out of China in January. Now we are learning that this disease existed long before January but medical professionals were hampered by the Chinese communist government in declaring an epidemic from a new coronavirus. However, in each early account from China regarding the severity and means by which the disease was transmitted has now been either discounted or was whole-heartedly proven false. In addition, it is now widely discussed (albeit gingerly) that the true numbers of infected and dead in China has either been somewhat misrepresented or is patently false.
China itself has admitted they have changed many times how they count positive cases. Due to the mortality rate of those infected in both Italy and Spain it draws into question the accuracy of China’s reported numbers. Poor and or inaccurate information out of China did have an impact on other countries, most notably Italy and Spain, and then the US, in how they initially responded to the outbreak.
Could the outbreak in other countries been better handled if China had been transparent in sharing everything they knew about the coronavirus? I think any rational and impartial person would have to answer yes. The final outcome from China’s misleading reporting is unknown, but in light of President Trump’s commentary regarding how the World Health Organization (WHO) handled the crisis in association with China, it would be safe to say that a continued tilt away from China in the coming years will pick up pace due to these events.
As noted in previous quarterly newsletters related to the trade “war” with China, they have a consistent pattern of bending the truth to conveniently fit their argument. It is now a widely shared view that China is enemy number one of the western world. This is not simply conservative media fodder. The Pew research center has done extensive research (chart on the following page) in the area of US citizen’s perception of China and it’s the worst in over 14 years. We expect negative perception toward China will only deepen after the coronavirus outbreak.
What is the “end game” in how it relates to Chinese and US relations? Trying to forecast where we will likely go, in our opinion, can be easily projected if we look backward. In relation to trade, new light has been focused on China as it relates to human rights, pollution, and predatory manufacturing. Now, throw in the coronavirus and we can only assume future reliance on China will be diminished. Within China, the communist party can easily control the coronavirus narrative. The rest of the world is not so gullible or prone to take their statements at face value. Due to the severe human and economic suffering that has been unleashed on the world one can only assume that we will enter some sort of “cold war” with China due to a multitude of factors.
Even preceding the trade war, global manufacturing was actively seeking out alternative locations to China. We expect this trend to continue and benefit other countries in Southeast Asia and India. Plus at some point, we expect some sort of “America First” manufacturing and domestic stimulus/infrastructure bills to take shape. This will help buffer the economic hangover we will likely experience when the worst of the coronavirus has passed. Due to unprecedented federal fiscal support, enacting wide-scale domestic infrastructure projects should be easier to swallow politically post-coronavirus.
But, in the meantime our reliance on overseas goods, most notably personal protective equipment (PPE) and pharmaceuticals may finally draw critical attention to our Achilles heel of reliance on foreign manufacturing. Currently, the rapid and massive increase in jobless claims is mainly a function of layoffs in the leisure and hospitality sectors (hotels, restaurants, bars, etc.) hair salons and personal services, and retail trade. Much has been written about our ability to “turn on” those industries with the flip of a switch. Many of these services, like restaurants and hair salons, can effectively be switched “back on”, but they will likely have a mild hangover for some time. Other industries like leisure (hotels, flights, tour operators, etc.) can also be resumed but will have a more severe hangover for a longer duration. Again, when you have an extreme random event, such as a true Black Swan, predicting the duration of the after-effects and associated recovery can be very difficult. This leads us to support of the economy and where it will be directed and for how long.
Government action to support the economy has been unprecedented in both speed and size. Now, one can debate the current level of adequacy and potential moral hazard with these programs, but again this is an event with unknown outcomes. We can’t really at this point discuss whether it will be “effective”, as this attempts to predict the future and is a “fuzzy” term. So, in terms of the Federal Reserve, they took quick action to reduce interest rates back down to financial crisis levels. It should be noted and has been discussed before in past quarterly letters, simply because money is cheap (rates have come down) if I don’t want or need to take on a loan I’m not going to rush out and borrow money. Especially in light of a falling economy, this could simply be an exercise of throwing more money on a bonfire.
From the graph above we can see that the Fed has effectively reduced rates to zero, again. In 2008-2009 we witnessed a financial crisis that pushed rates to zero for many years. Then, as the economy recovered the Fed “normalized” (or, raised rates off zero so they would have room to cut if another crisis emerged) and low and behold here we are again with another crisis just after the Fed said they would put rates on hold due to an “appropriate level” of interest rates. Let us agree that we currently have a very accommodative Fed and a very low level of interest rates. Plus the Fed and other central banks have made coordinated statements to do “whatever it takes” which is a tag line taken from the last financial crisis. The interesting thing is, we had a very brief rally after rates were cut and then the stock market promptly rolled over. So, the market was telling everyone at that time, too little too late and more would have to be done on the fiscal side. A quote from the Federal Reserve website:
“The Federal Reserve’s balance sheet has expanded and contracted over time. During the 2007-2008 financial crisis and subsequent recession, total assets increased significantly from $870 billion in August 2007 to $4.5 trillion in early 2016. Then, reflecting the FOMC’s balance sheet normalization program that took place between October 2017 and August 2019, total assets declined to under $3.8 trillion. Beginning in September 2019, total assets started to increase.”
As of this writing “total assets started to increase” would be another grand understatement of the decade as we have seen unprecedented money creation at the Fed. Safe to say we are in unique times.
Regarding the chart above, one might look critically at the hockey stick-shaped line and ask, is this correct? Yes, this is right off the Fed’s website and shows the massive increase in money supply in an effort to fight the effects of the coronavirus. It should be noted also, that the Fed has been acting in concert with the Treasury to create many special purpose entities to help support certain sectors of the financial markets that were experiencing extreme stress due to a lack of liquidity. This is straight out of the last financial crisis playbook. A combination of both Fed and Treasury action likely put a floor under asset prices.
In March, basically everyone was selling, with few buyers, which overwhelmed many financial actors’ ability to efficiently sell positions. A true “liquidity crisis”, it was called. In effect, the Fed has become (again) the buyer of last resort. This will be discussed in financial textbooks for years and decades to come. Questions like, “did the Fed overstep?” and “did the Treasury do the right thing with issuing checks directly to taxpayers?” will have to be answered at a later date. No one should pretend to know the answers to these questions at this time. But, it must be emphasized that action was required to avoid a domino effect of failures similar to the last financial crisis and the pain would be much worse had the Fed and Treasury not acted. So, we can at least take solace that the Fed and Treasury are extremely supportive of the economy in these trying times. Now, this begs the question: What does that get us? Are assets “cheap” or “expensive”? In an attempt to answer these questions we will rely on some giants in the asset management arena.
As the corona virus was taking shape it must be noted that financial markets initially moved higher. As previously mentioned here, the coronavirus was widely reported in China during January. However, possibly because as Americans we thought it couldn’t happen here, new highs were made in the stock market in early February. But, as the realization that the virus had migrated to the US and was about to rip through our country the market assimilated or “realized” this would cause untold economic damage and sold off with a speed not seen in modern history.
Did the market sell-off too much or not enough? The problem is we still do not know. But, when the Dow went down into the 18,000 range we could safely say there was some history around markets selling off about 40% and typically a bottom is found in this range. We can discuss PE ratios, debt levels of corporation, sales declines until the cows come home. But, it is our view that the discussion of historical valuations are not the prime movers of markets during extreme events, as was the case with the lows we hit in March. It must be stressed that financial markets are forward discounting mechanisms which can be prone to excess on either the upside or downside during both overly optimistic and pessimistic outlooks.
What does this mean? The market in its’ correct action (our opinion) of selling off during March was attempting to “price in” a global pandemic with unknown consequences. Going back to our Black Swan discussion, the market getting this exactly right is near impossible. Plus, after the market hit bottom it was not incorporating future government action to support the economy, as it was unclear what government action would be taken. It is our belief this is why the bottom is in. The market tried to assimilate coronavirus information and dove straight down, then government seeing the potential for a cascading selloff becoming a defacto black hole and sucking in other asset classes into a self-reinforcing negative feedback loop, then steps in to support the economy. This new action is then assimilated into the stock market (or asset prices). Now again, has the market moved too far too fast off the bottom? Maybe! Again, we don’t know.
In March we bought assets that were extremely cheap. Now, in hindsight, we have learned that many, many other very large investors were doing the same thing. A quote from Doug Kass, “The best time to buy generally comes when nobody else will; other people’s unwillingness to buy tends to make securities cheap. But the factors that render others averse to buying will affect you, too. The contrarian may push through those feelings and buy anyway, even though it’s not easy.” Basically Kass is saying, if you have the stomach, you want to be a buyer when maximum selling pressure has kicked in.
In another giant’s outlook on the market, we can look to Howard Mark’s of Oaktree who wrote, “The bottom is the day before the recovery begins. Thus it’s absolutely impossible to know when the bottom has been reached…ever. Oaktree explicitly rejects the notion of waiting for the bottom; we buy when we can access value cheap.” Further, he states, “The more you want to garner potential gains and don’t mind mark-to-market losses, the more you should invest here. On the other hand, the more you care about protecting against interim markdowns and are able to live with missing opportunities for profit, the less you should invest.” While Kass’ mantra is simple, buy when others are panicking and selling, Mark’s inferences are much more nuanced.
First and foremost, Howard Mark’s is admitting his fallibility (yes he is a billionaire, but cannot be perfect when it comes to timing). Second, he is basically saying that you have to check in with yourself and understand your own risk tolerance that might drive you to make poor investment decisions (likely selling when things look very bad and locking in losses). And on the flip side, you will then not want to be a buyer because you will tell yourself 100 reasons why things look terrible at that point in time.
This is a classic example of behavioral finance driving people to make poor decisions in times of stress. The biggest catalyst for these stress-induced decisions is money, pure and simple. When someone sees that their nest egg has declined in value they go into defensive mode. But, we as a firm had taken a defensive position going into this crisis and had the luxury of trying to deploy capital as things were in full meltdown mode. But again, as Marks said above, we only know if we have bought at the bottom after the recovery has begun. Did we time things perfectly? No. But, as discussed below we tried to make sense of the crisis and buy assets that had massive sell-offs. We can only try to buy assets that seem to be a good value at a certain point in time. It is our belief that continued government support and a “soft opening” of society will begin soon which will support asset prices. Will we see some bumps along the way? That would certainly seem reasonable.
The hardest thing to do in times of crisis is an attempt to look past the immediate wreckage of today, out to what might happen with support from a constructive framework that may either help support or even fix today’s problems. As mentioned, will we have bumps on the way to recovery? It would seem impossible that we will not have some hiccups as we begin to recover from the coronavirus. This is a global problem and the sheer number of people working on a solution is unprecedented. Solutions will be found, however imperfect, to pull us out of the mess we are in. We remain confident that both a soft opening and federal support for the economy may set up a positive backdrop for investment returns in the coming years.
It is becoming widely acknowledged that we cannot afford to keep the economy shut down forever, we expect to see some kind of plan to reopen taking shape very shortly. We also expect the reopening process to be politically charged with passionate arguments on both sides of the debate. But, even those that have advocated for a complete shutdown are coming around to the realization that this is not sustainable for any length of time. This brings us around to how to deploy client’s money in a still uncertain future. When the market was in full panic mode, it seemed prudent to buy a basket of assets that are geared toward high-income selling for extremely low prices. In an uncertain future, income-oriented portfolios should perform well with very low-interest rates.
We have sought to add positions in companies and securities that are geared for yield. There were many pockets in the financial markets where the severity of markdowns seems quite excessive. In short, energy stocks, high yield bonds, apartment REITs, and mortgage-related credit all were priced for absolute Armageddon. It seems reasonable that these assets and services are tied to real things that people need (like gasoline and housing) and while the world will be somewhat different post-coronavirus, it will actually be very much the same. People will still live in apartments, still drive cars, still continue to pay their mortgage, etc. But, even with a future return to normalcy we still are sitting on a fairly large cash position. This, in effect, still allows us the flexibility to take advantage of opportunities as they arise and avoid going “all in” on a speedy recovery from the coronavirus.